Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Search

Subscribe via e-mail

RSS Feeds

Disclaimer

David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

Observable Inputs – market participant assumptions developed based on market data obtained from sources independent of the reporting entity

Level 1 Inputs – Unadjusted quoted prices in active markets for the identical assets and liabilities that the reporting entity has the ability to access at the measurement date. Examples: Treasury bonds and exchange traded securities.

Level 2 Inputs – Other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active. Examples: loans traded within the secondary market and plain vanilla interest rate swaps.

Unobservable Inputs

Level 3 Inputs – Entity specific inputs to the extent that observable inputs are unavailable. Because there is little to no market activity, these inputs reflect the entity’s supposition about the assumptions of market participants based on the best information available in the circumstances. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort. Examples: credit enhancing I/O strips and private equity securities.

Level 3 – significant use of private firm-specific data, or public data not derived from the markets (think of a life insurance industry standard mortality table)

Now, I’m not a fan of SFASs 157 & 159, or any of the current statements dealing with intangibles. Even level 1 is subject to problems when markets are less liquid. I’ve known of situations where a bond manager found himself holding a disproportionate share of the market of a publicly tradable bond, where it almost never trades because he owns so much of the issue. Where do you mark that? That’s just level one!

Aside from AAA securities, most asset backed bonds never trade. Level 2 comes into play here, because the dealers estimate a pricing grid from what few transactions take place. with “fair value” accounting, there is no way to avoid mark-to-model, but there are significant possibilities for error.

The classic case of level 3 is how one estimates the changing value of private equity investments over time. Discounted cash flow anyone?

As a result of the changes, we have to be a lot more careful in how we interpret the financial statements of financial companies. The game just got a lot more complex given the new fair value accounting rules.

Position: none

After I wrote that, a friend of mine e-mailed me saying that Private Equity accounting was for the most part conservative at present, but that there was some pressure to use fair value accounting to smooth results. He also thought the use of these methods wouldn’t make private equity correlate more closely with public equities. I think he is onto something there, and that could affect that amount allocated by pensions and endowments to private equity. On the flip side, if the returns are smoothed through these accounting methods, the standard deviation of returns would drop, which is a bigger effect than the correlation effect. So allocations might go up, and some Private Equity managers, believing the smoother returns, might be tempted to lever up more.

One other note: I expect that companies with high percentages of level 3 assets will trade at discounts to relative to their peers. Accounting complexity and opaqueness always have valuation discounts. I see it in insurance for financial insurers, reinsurers, and long-tailed commercial lines. Uncertain assets and liabilities should always get lower valuations. Thus, aggressive users of fair value will wonder why their P/Es and P/Bs are so low. It’s because of the lack of ability of investors to verify the asset and liability figures used.

Share this:

Related

About David Merkel

David J. Merkel, CFA, FSA, is a leading commentator at the excellent investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited David to write for the site, and write he does — on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, and more. His specialty is looking at the interlinkages in the markets in order to understand individual markets better.
David is also presently a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. He also manages the internal profit sharing and charitable endowment monies of the firm.
Prior to joining Hovde in 2003, Merkel managed corporate bonds for Dwight Asset Management. In 1998, he joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
His background as a life actuary has given David a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that David will deal with in this blog.
Merkel holds bachelor’s and master’s degrees from Johns Hopkins University. In his spare time, he takes care of his eight children with his wonderful wife Ruth. View all posts by David Merkel →